Small Caps in a Tactical Position for Long-term Investment

investing in small cap
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India will underperform in the medium term due to Foreign Institutional Investors (FIIs) selling and premium valuations compared to its emerging market (EM) peers. However, we feel that it is a good time to consider stock ideas in the small caps category with value buying as the theme.

The resilience of India’s overall stock market can be understood by the fact that the total capitalization of the country is sustained at Rs. 266 trillion in the last one year. Positively, we can say that the nation’s stock market has maintained its total worth; yet, unfortunately, no new wealth has been generated in the past year. This data is reflective of the trajectory of the country’s broadest equity index, the Nifty 500. On a numeric scale, it gives you a flat digit; however, the reality is that the undercurrent was volatile, having corrected by 20% and rebounded. Some pockets have recovered, though the negative effect on small caps is sustained. About 2/3rd of the small cap constituents of the Nifty 500 continue to trade below the 200-day average price, an indication of a deep discount in price that may be lucrative for a long-term investor. We hold the view that India will underperform in the medium term due to Foreign Institutional Investors (FIIs) selling and premium valuations compared to its emerging market (EM) peers. However, we feel that it is a good time to consider stock ideas in the small caps category with value buying as the theme. 

As we know, stocks are categorized as large, mid, and small caps. Small caps have market capitalizations of less than Rs 10,000 crore (market capitalization = number of outstanding shares multiplied by current market price). Mostly, the three segments move in tandem, but the path varies based on liquidity, sentiment, the economic cycle, and stock and industry developments.

Now, the Nifty 500 index has 174 small caps. On average, they are down by -30% from respective 52 week high; the range is from -77 to -3%. Disruptively, 2/3rd of them are down below the 200 days average price; the average correction is -13%. On a price trend analysis, it is lucrative for a short and long-term investors.

India’s period between 2020 to 2022, was good for speculation and small caps. Small cap performance has been sceptic since the middle of 2022, as valuations exploded, and liquidity began to dwindle. The ongoing muted trend can continue in the short to medium-term as India sustains its underweight rating in the eyes of foreign investors. The domestic market is trading at a premium to developed and emerging markets, which are experiencing an uptick in economic growth while India is having a slowdown.

India’s main index (Nifty 50) trades at a valuation of 20x, above the long-term average of 17x. Similarly, midcaps trade at 24x, above the long-term average. India’s earnings growth is moderating, and foreign stock markets are more lucrative, trading at deep discounts. Furthermore, the world’s high interest rate, which is expected to remain high, will impact future valuations.

Comparing India’s valuation in-terms of the dollar, MSCI-India’s price-to-earnings ratio valuation is at 34% superior to MSCI-World, 106% to MSCI-China and 95% to MSCI-EMs. Historically, India has been trading at an average premium of 10% to the world in the last 10 years, currently 24% above the long-term rate. Similarly, compared to MSCI-China and MSCI-EM, it is at 43% and 27% above the long-term average, respectively.

Hence, in the short-term, it is speculative to predict that the worst is over because muted performance of the broad market will have an effect on the performance of small caps. But the price data depicts that small caps have experienced a significant correction. This is supported by the fact that the one-year-forward-valuation of the Nifty smallcap100 index is down by 33% to 16.2x from the peak of 24.2x, trading near the 10-year average of 14.4x.

Small caps trading at a discount to the main index…

Considering the fundamental point that small caps are trading at -19% discount to large caps below the long-term average, will limit further fall in price. And if the market falls more, we can expect a medium-term support and rebound, aided by powerful takers such as institutions and HNIs taking advantage of deep discounts. Monthly SIP inflows into mutual funds continue at a record high.

Secondly, we cannot forget the strength of the Indian stock market. The most liked market had upgraded to an extreme supreme valuation of plus 24x in 2022. The long-term aura of India continues to be agile as the top long-haul investment destination. A further correction of India’s market will depend on the international factor of a high interest rate cycle. In the near-term, we may not have a strong rally; however, the earnings growth of 10% and healthy GDP growth of 6 to 6.5% forecasted for FY24 will protect against a downfall and encourage growth at-least in-line with earnings growth on a medium-term basis. 

Understandably, the strength of the broad market and financial liquidity are crucial for the performance of small caps. However, today’s value-buy and discount valuations will attract smart investors to small cap stocks. It makes sense to chip into them on a long-term basis through a SIP style accumulation strategy.

Remember that stock selection is the most important skill required to make profit by investing in small and microcaps and to compensate the extra risk undertaken. An investor should dip into the type of stocks to invest, like business, growth, management, industry, and valuations. Professional recommendations from research and industry experts with company analysis/reports can be relied-on to identify stocks. It is good to know their strengths and weaknesses, as well as the market’s theme and flows. An active investor can investigate the fundamentals and financial trends through stock analysis and screening made available on trading platforms. The crux should be to focus on the long-term vision, the quality of products and services, the credentials of the management, and its strength in the industry.

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